Estimating and forecasting with a two-country DSGE model of the Euro area and the USA: the merits of diverging interest-rate rules

In this paper we estimate and forecast with a small-scale DSGE model of the Euro area and the USA characterized by diverging interest-rate rules using quarterly data from 1996Q2 to 2011Q2. These diverging rules reflect the differing mandates of the ECB and the Fed, respectively. Due to its primary objective of price stability, the ECB is supposed to conduct monetary policy by considering producer-price inflation only (single mandate), whereas the Fed is assumed to conduct its policy by taking into account the output gap in addition to producer-price inflation (dual mandate). In terms of the RMSE and the MAE, the DSGE model with diverging interest-rate rules outperforms a DSGE model with identical interest-rate rules in almost 70% of all cases for almost all variables across forecast horizons out of sample. It also compares well with BVAR benchmarks. For shorter horizons, we find some statistically significant differences in forecast accuracy between rival models. For forecast horizons three and four quarters ahead, the null hypothesis of equal forecast accuracy can seldom be rejected.